Let's return to the fundamental principle. In a perfectly competitive market, no firm realizes economic profits or rents. This suggests that the existence of economic profits suggests some type of market inefficiency. Now, for those of you may be trained in economics or simply just watch CNBC. This might seem surprising, aren't we taught that capital markets are efficient and that this is the hallmark of capitalism. You're talking about market inefficiency. Well again, for the existence of these economic profits, you must be exploiting some type of market inefficiency. So this is a very important point and one that I think is worthy of taking some time to dive into. So let's do a little Econ 101 here. Here have an industry and we have a classic supply and demand curve. Our demand curve is downward sloping. Why is that? Well, on our X-axis or a horizontal axis, we have the quantity demanded. On the Y-axis, or the vertical axis we have price. So the idea is as we lower prices, more people will demand a good or service, creating a downward sloping demand curve. On the other hand, we have supply coming from different producers. And the assumption is as prices increase, there's more supply that you're willing to provide. So we have an upward sloping supply curve. Now, the fundamental rule, if you will, a fundamental law of competitive markets is that prices tend to equal liberate where supply equals demand. So we have P1 here at that intersection of supply demand and that also implies a certain quantity demanded given by Q1. So this is great, this is what happens at the market level. But now let's consider what this means at the firm level. So consider an example, consider a T-shirt vendor outside the basketball arena at the University of Virginia. First question is, what price do they charge? But we're going to argue that there are what we call a price taker, meaning basically that they charge whatever the market prevailing prices in the market. Now, of course they could charge more than the market price, but if they do so, arguably they would sell no T-shirts in our example here, because people will go to a lower cost T-shirt vendor. They could charge less price for their T-shirts, but in this case we're trying to figure out how they can maximize their profitability and so you would argue that they would charge the maximum price they could with still being able to sell T-shirts. So in our graph we have two curves, we have our average cost curve and our marginal cost curve, AC and MC. The average cost has the shape that it does because it reflects the fact that there are probably some fixed costs to producing, in our case here, our T-shirts. So to produce just one T-shirt requires all the equipment, the van perhaps to bring the supply to the stadium working at the stadium. So it's quite expensive to sell that first T-shirt. But as we sell more and more, we spread out those fixed costs across the T-shirts we sold, lowering the average cost for T-shirts sold eventually though, maybe we'll run into a capacity constraint. Maybe we need to build another printing press. Maybe we need to buy another van or hire another person. And as a result our average cost curve goes up. The marginal cost curve, the MC, represents the marginal cost to sell one additional T-shirt. How much more does it cost for me to sell that next T-shirt? And technically it is the derivative of the average cost curve. Now, our decision rule here, if we did the math is that the firm should set the quantity they sell to the place where price equals marginal cost. And you can see this graphically by looking at the spaces that it creates, P1 times Q1 gives you your revenue. This tells you the amount of money that you bring in from the sale of the T-shirts. q1 times AC gives you your cost, this is your average cost times the quantity sold gives you your total cost. And that leaves then a profit left over at the end of the day. And one can play around with different q1 values. But you'll find that setting q1 such that price equals marginal costs, maximizes the swear of that green space that's left over after subtracting cost. All right, so if you're T-shirt vendor, this looks great, we're making some money all is good with the world. But what do you imagine happens next? Well, one could argue that others will observe the T-shirt vendor making money and decide I'm going to sell T-shirts as well. I'm going to enter into that market and begin selling T-shirts. What does that do to our industry? Well, what it does is effectively shift out our supply curve. Now, for any given price, there is more supply available on the market, but our laws of supply and demand don't go away. What we find then, is that at the new supply curve and where it crosses our demand curve, we have a lower price, so prices come down as a result of the century. And we now sell actually more T-shirts as an industry. Once again, supply must equal demand, we get P2 and Q2. Prices come down quantity sold as an industry goes up. But our firm is still a price taker. So there are new prices now P2. And our decision rule still holds where we set the quantity sold such that price equals marginal costs, giving us Q2. So what happens is, while the market is expanding the amount we sell goes down. In essence, the new entrance steals market share from us by entering into the industry. Well, what does this do to our profitability? P2 times Q2 once again gives us our revenue. Q2 times their average costs gives us our cost, and in the way I have it drawn here, profits are competed away. Now, technically in a competitive market, economic profits are accounted away, but actually accounting profits can still exist. So while I've illustrated it here, with all profits going away, it is possible for there to be a little bit of green area there that might exist even in a competitive market. The logic is as following. When a potential competitor might decide to enter the industry, they'll see what their impact will be, and they might decide not to enter if they see the profitability gets so small that they're better off investing their money in some other alternative. This gets at the heart of this idea of the opportunity cost of capital. So it's not that accounting profits are competed away, but it's that these economic profits are competed away, once we factor in that cost or the capital. So once again, the fundamental principle of business in competitive markets, economic profits are competed away and then flipped around. For there to exist economic profits, there must be some market inefficiency that prevents this race, if you will, to the bottom of perfectly competitive markets.
